Wednesday, 10 August 2011

The Cost of Cost Studies

Back in 2009, Matt and I got a bit annoyed that BERL's estimate of the social cost of alcohol was being used for policy purposes by the Law Commission; the "social costs" it tallied included a lot of money spent by drinkers on their own alcohol, for example; Sir Geoffrey Palmer's then contrasting of the alcohol excise tax take with BERL's social cost figure was then worse than nonsense. We tore the number up and put up a working paper with some of the findings.

Last year, we were contacted by NABIC - the industry group representing Australia's brewers, distillers, vintners and alcohol retailers - asking if we might cast a similar eye over Australian estimates produced by Collins and Lapsley. We were somewhat familiar with Collins and Lapsley's method as that was the model used by BERL. And so we agreed; funding was provided via a consulting grant administered by the University of Canterbury and subject to pretty strict academic freedom provisos. For example, I insisted that we retain ownership of the produced document: if we found things that weren't particularly welcome, the document then couldn't be buried. And NABIC's been great; the only pressure we ever came under was to get the damned thing finished while the September and February earthquakes rolled on through and I was locked out of my office for considerable periods of time; we've appreciated their understanding as I've worked through the earthquake complications.

We brought in Brad Taylor to assist with the literature review; Nick Sander and Rachel Webb provided excellent additional support. I presented an initial draft of the results at the NZAE meetings in Wellington in June, then a slightly updated version of the results as part of the Dodgy Awards at the Australian Conference of Economists' Policy day. Since then, I've cleaned the paper up, partially in response to very helpful comments from co-blogger Seamus. It is now released as a University of Canterbury Economics Department working paper. Next, we'll be splitting that rather weighty tome into a couple of pieces for submission.

The biggest problem with the "cost of illness" approach used by both BERL and Collins & Lapsley is the counting of private costs as social. The innovation introduced by Collins & Lapsley, and followed by BERL, was to present the resulting figure as representing "net" social costs. Private benefits of alcohol consumption were deemed by Collins and Lapsley not to exist because consumers could not meet very stringent requirements for rationality and information. Collins & Lapsley argue that if consumers are not fully informed, consistently rational, and required to bear the full costs of their consumption, the "resultant costs" are social - in other words, there can be no private benefits to offset private costs if there exists any potential failure of the conditions of the first welfare theorem. And this is plainly nonsense: these sorts of failures can cause some deadweight costs but they hardly destroy the potential for private benefits. Collins and Lapsley write:

“Being fully informed about the private costs of abuse requires the abuser to have access to, and have the ability to process and evaluate, epidemiological information on the effects of drug use. It also requires the drug user to be able to evaluate the probable future health and other costs resulting from the drug use. It is difficult to believe that drug users, by their nature, are fully-informed, or even well-informed, about the costs of their abuse.”

We have to wonder whether the standard applied to alcohol could be applied to other forms of consumption: I don't think that I could eat a banana in a manner consistent with Collins & Lapsley's requirements because I don't fully understand how the body metabolises potassium from the banana and how that affects the balance of electrolytes* in the body. And as my wife and I have joint banking accounts, I don't bear the full costs of buying the banana. It's a strange world Collins & Lapsley work in.

Assuming zero benefits from alcohol consumption allows Collins & Lapsley to present a measure of "net" social costs that includes private costs. If we use a more standard economic approach that only counts external costs, less than $4 billion of C&L's $15 billion can properly be counted as social cost. That's roughly on par with the aggregate alcohol excise tax take. Marginal analysis is required for assessing the adequacy of the tax regime; it's possible that an alcohol excise tax increase could be welfare enhancing even if the total cost figures roughly match the tax take. But it's unlikely. Recall that heavy drinkers are about sixty percent as price responsive as moderate drinkers; more harms likely get imposed at the margin on marginal drinkers than get averted among heavy drinkers with a tax hike.

We also took the opportunity to revisit our analysis of the BERL figure. And, we found that we'd made a couple of errors there.

First, we realized that we had double counted when we both excluded private costs of forgone earnings and kept BERL's measure of the transfer benefits of resources released for others' consumption. BERL didn't call us on this one when they critiqued our initial study, and we didn't realize it until we had a rather more thorough understanding of the C&L model on which BERL was based. This brought the overall cost figure up from an amount trivially below the New Zealand excise tax take to an amount a bit higher than the tax take.

Second, we realized that BERL had double-counted in tallying both the costs of premature mortality and the value of forgone wages. BERL, and Collins & Lapsley, used a measure of willingness to pay to avoid loss of life in calculating the value of a life year lost through premature mortality. That figure includes all the value of forgone production and other costs of premature mortality; it's telling that NZTA figures on the costs of car crashes include the production losses from injury but no measure of forgone production with premature mortality - it's already included in the value of the statistical life lost. So you can't count both forgone production and the value of statistical life-years lost. Correcting this did not much affect our overall figure as the vast majority of forgone production costs accrue to the drinker himself and so were already excluded as internal. But if you care more about the overall cost figure that includes both private and external costs, the double-counting adds substantially to the final figure.

We were unable to correct BERL's health cost figure to account for that they zeroed out those disorders where Collins & Lapsley concluded that alcohol consumption reduced aggregate health costs; consequently, our figure remains overstated. The true figure would have external costs rather closer to the tax take. But, again, marginal analysis would be required to assess whether excise increases (or decreases) are warranted.